Regional Focus

Australia Q2 – Cash Collateral Reinvestment

Market Update

The second quarter was both rewarding and challenging for the Australian cash market. For most of the quarter, cash returns averaged on or around the 90-day Bank Bill Swap rate, while weighted average duration remained around the 30-day range (obviously well below 90 days). Most of the value J.P. Morgan has extracted from the market has been in bank “Term Deposits.” However, we have reached a point where the market is no longer paying a premium for deposits because domestic banks are in a strong balance sheet position, having  completed a significant balance sheet restructure away from short term debt (Chart 1) and towards domestic deposit (sic Term Deposits).

Chart 1

This “sea change” from short term debt to domestic deposits has been driven by regulatory changes (Basel III and APRA liquidity guidance), which J.P. Morgan has extracted significant value from. However, the tide is changing for a couple of reasons.

1. Fully Funded - having completed the restructure banks find themselves fully funded (Chart 2) and are no longer seeking/rewarding term deposits at the same levels.  
2. Credit Growth - the market appetite for credit has declined significantly (Chart 3), and demand from banks to borrow cash has declined in tandem.

Chart 2

Chart 3

In April the futures market was pricing in a rate rise for June/July, this has since been pushed out. The turning point was April’s loss of 22,100 jobs, resulting in an unexpected downside to the market. Since then the front part of the curve has flattened considerably for the coming months. While it has not started to show in the market forecasts as yet, some participants are now talking about a possible rate cut rather than rate rise.

In June, Moody’s placed a total of 12 banks on negative watch for various reasons. The impacted  banks and the reasoning for Moody’s negative watch are detailed below.

1. Greek Exposure - BNP Paribas SA, Societe Generale SA and Credit Agricole SA.
   In light of their holdings of Greek public and private debt and any inconsistencies between their ratings now- and potential impact of a Greek default. It looks as though a possible sovereign default will have wide-reaching impact across the global banking system and that the rating agencies have looked to be more proactive than they have been in the past in identifying the exposed entities sooner rather than later.
2. Government Backing - Royal Bank of Scotland, Bank of America, Citibank and Wells Fargo. 
   Moody’s explained these banks could not continue to rely on government backing and therefore they were reviewing their credit standing on the basis that government support would be withdrawn.
3. Japan (Tsunami Impact) – Bank of Tokyo Mitzubishi, Mizuho and Sumitomo.
   With the fall out from the March 11 Tsunami yet to be fully quantified, Moody’s has moved early based on the latest GDP impacts. 

Action Taken

Generally speaking, client guidelines* for AUD cash do not permit J.P. Morgan to purchase any security while on negative watch. Therefore, for all Banks currently on negative watch below are actions the firm will be taking:

1. J.P. Morgan has not repurchased any of the assets that were rolling overnight (on a day to day basis) and in effect maturing everyday
2. With the names that had a longer maturity and still may not have matured to date J.P. Morgan has not sold these and they are still held in cash portfolio as permitted in the cash guidelines. However, we will not be buying back into these assets upon maturity if they are still on negative watch at this point in time.

*The only exception to the above being any names that are A1+ rated, where the cash guidelines permit J.P. Morgan to continue buying these names.

Impact

Due to the market events described above J.P. Morgan has seen:

1. Term Deposit rates decrease (particularly overnight rates) as domestic banks are fully funded and no longer need to pay-up to attract deposits.
2. A reduction of investment options due to Moody’s negative watch. This reduction results in deposits being placed with alternative approved Banks, (e.g., UOB) not previously used as they did not offer as attractive rates.

The end result of the decrease in term deposit rates and the reduction of investment options is that spreads have dropped some 4bp in June and we expect overall spreads to decrease a further 2-3bp. Conversely, we have added some duration to the book as banks are looking to move away from overnight funding to longer term funding options to meet the APRA liquidity requirements. Finally, we are also looking at supranationals and other options to provide further diversification.